Monday, September 13, 2010

Efficiency vs Equality

The big issue in the UK, seems to be where should spending cuts fall. There seems to be a widespread acceptance that spending cuts are necessary to 'strengthen the economy.' However, as I've talked about previously, given fragility of recovery, spending cuts next year, could weaken economic growth and fail to improve Britain's prospects as many believe. (IMF and spending cuts)

Anyway, the in medium term and long term, there is no escaping the fact Britain does need to provide a clear plan to redress it's structural deficit. If markets can see a plan for deficit reduction, then they will be willing to lend in the short term to finance cyclical deficit.

From an economic perspective, the most attractive spending cuts, will be those that do not affect infrastructure and economic incentives. Therefore, the best target will be things such as:

Cutting spending in these areas will in many instances provide better incentives to work. e.g. lower benefits will reduce the dependency ratio. Social security is also by far the biggest area of public spending.

However, it comes at an obvious cost that these spending cuts will worsen inequality.

Raising retirement age will negatively impact poorer workers who don't have recourse to good private pension.

Cutting welfare benefits may increase some work incentives, but, it will directly impact on income levels of poorest households.

For some reason, health care is considered 'sacrosanct' And no politician is willing to contemplate cuts here. But, given the rise in NHS managers and bureaucrats, I don't see the wisdom of ring fencing the second largest budget in government spending. The NHS is a noble recipient of spending. But, that doesn't mean throwing money at the NHS is always guaranteed to provide a good return in terms of health care.

The easier spending cuts will be to cut back on infrastructure projects like building roads, railways, investing in new schools e.t.c. These are easier to cut, because here there isn't the same political will. But, cutting back on infrastructure spending is something that will be regretted in future years. The market fails to provide many 'public goods' - goods with positive externalities. A budget crisis doesn't mean that the market will suddenly start investing in better transport.

It is likely spending cuts will be widespread, but, indications are that they will impact on the poorest sections of society the most.

Indeed, the TUC’s research, carried out by economists Howard Reed and Tim Horton, claims that the UK’s poorest 10 per cent will be hit 13 times harder by the cuts than the richest 10 per cent in the year 2012-13.

It's a balancing act. If we cut spending, we have to be mindful of economic incentives. The problem is increasing economic incentives to work, usually comes at cost of increasing inequality. However, it is possible to improve work incentives without unnecessary inequality. (see: Poverty trap and how to overcome it)